Bad Outcomes:Bad Outcomes: GGood Intentions, ood Intentions,

Social Policy, Informality and Economic Growth in MexicoSocial Policy, Informality and Economic Growth in Mexico

Santiago LevySantiago LevyInter-American Development Bank.Inter-American Development Bank.

2

BackgroundBackground

1.) Two aspects of social policy need to be jointly considered:

– its impact on social indicators properly (how effectively are workers protected against risks, how effectively is income being redistributed, how human capital is accumulated and so on); and,

– its impact on incentives to workers and firms along dimensions that affect productivity and growth.

2.) These issues are relevant to:

– the effectiveness of social programs;

– understand the “productivity puzzle” in LAC; and,

– poverty and the “post-CCT” discussion.

3

Institutions, Workers and Social ProgramsInstitutions, Workers and Social Programs

4

Mexico’s laws make a fundamental distinction Mexico’s laws make a fundamental distinction between salaried and non-salaried laborbetween salaried and non-salaried labor

Salaried workers have a boss/firm and are paid a wage; there is a relationship of subordination.

Non-salaried workers are self-employed, or have non-subordinated relationships with firms: contracts to elicit effort or share risk, with commissions, profit-sharing or other pay structures.

Workers

salaried (firm involved)

non-salaried

self-employed (no firm involved)

comisionistas (firm involved)

5

Social security and social protection:Social security and social protection:

Social security Benefits are bundled and obligatory. Its costs per worker are:

Tf = [health insurance retirement pensions disability pensions life insurance work-risk pensions day care centers housing loans contingent costs of severance pay transaction costs of compliance].

Workers’ valuations depend on preferences, access and quality of services, and so on. Let denote the value to the worker of social security benefits. The utility of a salaried job is:

Note: Tf includes labor regulations

Social protection Benefits are unbundled and voluntary. Its costs per worker are:

Ti = [health + retirement pensions + day care + housing]

The utility of a non-salaried job is:

f

[0,1]

f f f fU w T

i i i iU w T

NOTE: Poverty programs social protection programs

6

Labor market implications of social programs Labor market implications of social programs

(1 )f fT

Total Costs and Benefits of Salaried and Non-Salaried Labor Salaried labor Non-salaried labor Costs to firms

f fw T iw

Benefits to workers f f fw T i i iw T

Econometric estimates suggest that for unskilled workers:

Tax on salaried labor = 26% of the formal wage rate

Subsidy to non-salaried labor = 8% of the informal wage rate

The total tax-cum-subsidy to salaried vs. non-salaried unskilled labor implicit in Mexico’s social programs is in the order of 34%.

i iT

(1 )f fT

7

Formality and InformalityFormality and Informality

“Informality is a term that has the dubious distinction of combining maximum policy importance and political salience with minimal conceptual

clarity and coherence in the analytical literature”. Kanbur (2009).

8

Definitions:Definitions:• I follow Kanbur (2009) defining formality with respect to “a” regulation. I focus

on social policy, so the relevant regulation in this case is coverage of social security.

• Formality and informality result from the intersection of the ambit of application of that regulation, and its enforcement.

Applicable Not applicable

Comply

Salaried worker enrolled by firm in social securityFormal & legal

Self-employed and comisionistas beforeadjusting to regulationInformal & legal

Do not comply

Salaried workers notenrolled by firm in social securityInformal & illegal

Self-employed and comisionistas afteradjusting to regulationInformal & legal

Enforcement:firms should enroll workers in socialsecurity

Regulation: workers should have coverage of social security

9

Some observations:Some observations:• Informality is not defined by the size of firms (many micro and small firms hiring salaried workers in Mexico are formal);

• Informality is not equivalent to illegality (not all informal workers in Mexico are salaried);*

• Informality is not equivalent to non-salaried (many informal workers in Mexico are salaried);

• Informality is not equivalent to poor workers (many informal workers in Mexico have high earnings, and some poor workers are formal).

(*Firms hiring salaried workers but not enrolling them in social security are expressly violating the Law; the illegal act is committed by the firm, not the worker.)

10

Workers Mobility in the Labor Market Workers Mobility in the Labor Market

11

1997 generation: average permanence during 10 years1997 generation: average permanence during 10 years

On average, high (low) wage workers who were enrolled in IMSS in 1997 have been in formality 77% (49%) of their time.

5.9

19.55.5

13.8

4.4

10.7

4.7

8.9

4.9

7.3

4.8

6.4

4.9

5.7

5.4

5.4

8.0

6.1

51.6

16.2

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

High wage Low wage

2,320,389 workers 3,707,089 workers

10 years

9 years

8 years

7 years

6 years

5 years

4 years

3 years

2 years

1 year

12

Distribution of workers by years in formal employment and Distribution of workers by years in formal employment and frequency of entry and exit into formality, 1997-2006frequency of entry and exit into formality, 1997-2006

f(1) f(2)f(3)f(4)f(5)f(6)f(7)f(8)f(9)f(10)

12

34High wage 5678910

1234Low wage 5678910

5 years, f(2), 46.9%

1, f(2), 100.0% 10, f(1) ,

100.0%

5 years, f(2), 77.0%

1, f(2), 100.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

% o

f w

ork

ers

wit

h f

(n)

entr

ies

and

exi

ts

by

year

s in

fo

rmal

em

plo

ymen

t

Years in formal employment

f(Number of entrie

s and exits)

NAverage years in

formalityHigh wage 2,320,389 7.7Low wage 3,707,089 4.9

13

8.0 5.9 66.5 13.8 5.8

54.8

24.9

14.5

2.43.4

18.2

1.4 2.3

74.6

3.4

8.1 36.1 14.0 31.510.3

Employment surveys*: around 20% of all workers Employment surveys*: around 20% of all workers change status change status in one yearin one year

Status Status in 2006 in 2006 of 2005 of 2005 formal formal low low wage wage workersworkers

Status in Status in 2006 of 2006 of 2005 2005 formal formal high high wage wage workersworkers

Status in 2006 of 2005 openly unemployedStatus in 2006 of 2005 openly unemployed

Status in 2006 Status in 2006 of 2005 self-of 2005 self-employed and employed and comisionistascomisionistas

Status in 2006 of 2005 informal salaried workersStatus in 2006 of 2005 informal salaried workers

14.3

73.2

7.13.5

1.9

*Workers 16-65 who did not change location, and were continuously interviewed from 2005 II to 2006 II.

14

Two key empirical results…Two key empirical results…

1. Low wage workers have lower average permanence in formality than high wage workers;

2. Low wage workers have greater frequency of entry and exit in formality than high wage.

The problem for low wage workers is not “entering” into a formal job at any wage. The problem is that they have infrequent stays in formality and earn “low” wages.

This contrasts with the “barriers to entry view”, that suggeststhat workers in the informal sector cannot get formal jobs at any wage. (But let’s not get caught in semantic discussions.)

15

……and some key conclusionsand some key conclusions

• Need to distinguish between entering a:

stable formal job vs. an unstable formal job

with a good wage with a bad wage.

• Need to shift attention from the “formality“ of jobs, to issues of stability and productivity of jobs;

• Need to focus on the impact of social programs on firms’ incentives to hire salaried workers legally or illegally, to offer non-salaried jobs, to offer permanent vs. transitory contracts, to train workers, and so on.

• Need an integral (or general equilibrium) approach.

16

Implications for social policyImplications for social policy • Distinction between “formal worker” vs. “worker at present hired

formally”. Most workers have spells of formal and informal employment.

[There is (almost) no such thing as a formal worker].

• Some firms hire formal and informal workers simultaneously.

• Only when workers are formal do they consume the bundle that the government wants (health, life and disability insurance, save for retirement, severance pay).

• Coverage against risks erratic and incomplete: when formal

yes, when informal, partially (given unbundled nature of social protection programs).

17

An example from retirement pensionsAn example from retirement pensions

The average contribution density in the 1997-2007 period was 45%. Replacement rates will be low, particularly for low wage workers. Most low wage workers will not qualify for the guaranteed minimum pension (at least 25 years of contribution).

8.5

16.1

55.4

18.1

11

14.8

8.0%

11.8

43.7%

12.3

0-20 20-40 40-60 60-80 80-100

Share of time that workers have contributed since account was created

High wage Low wage

Data from 37.8 million individual retirement accounts, of which 79% are low wage and 21% high wage.

18

Social Programs, Welfare and Social Programs, Welfare and ProductivityProductivity

19

Impact of social programs on firms and Impact of social programs on firms and workers (minimum structure of the problem):workers (minimum structure of the problem):

I first ignore subsidies to social security ( = 0). Initially I assume all behavior is legal (or perfect enforcement).

I explore solutions to [Lf, Li, wf & wi] depending on values of [Tf, Ti, , ].

f

fi

Formal firms hiring salaried workers maximize profits

Informal firms hiring non-salaried workers and the self-employed maximize profits (to simplify I add both in a single demand)

Workers search for jobs to maximize utility

All workers are employed

/ [ (1 ) ] 0wf f f f fp Q L w T

/ 0wi i ip Q L w

( )f f f i i iw T w T

f iL L L

20

In the beginning…. (TIn the beginning…. (Tff = 0 and T = 0 and Ti i = 0)= 0)

In the absence of social security regulations the distinction between salaried and non-salaried employment has no welfare or efficiency implications.

21

Social security is created (TSocial security is created (Tff > 0)…. and fully valued ….but no > 0)…. and fully valued ….but no

social protection (Tsocial protection (Ti i = 0). = 0). Formality and informality are “born”.Formality and informality are “born”.

There is no impact in the labor market except in the form of payment to salaried workers. The government’s social goals are accomplished with Lf* workers. Non-salaried workers are not covered against any risks. The expressions formal and informal workers have a precise meaning. Informal employment is efficient.

1f

22

When < 1 there is a tax on salaried labor. Firms hiring salaried workers reduce employment. The government’s social goals are accomplished with Lf’ workers and not at all with (L – Lf’) workers. A component of informal employment is socially inefficient; average labor productivity falls.

f

Next, social security does not work well…..Next, social security does not work well…..

f < 1

f < 1

23

In parallel, the government introduces programs to In parallel, the government introduces programs to protect informal workers….. (Tprotect informal workers….. (Tii > 0) > 0)

Social protection programs act like a subsidy to informal employment. However, now informal workers can voluntarily access unbundled social protection benefits, while fewer formal workers consume bundled social security benefits. Impact of Ti on workers’ utility is positive, on social welfare ambiguous, and on productivity negative. Gap in MPL widens.

24

Note that:Note that:

• Social protection programs widen the gap between the marginal product of formal and informal labor.

• If one ignores the issue of who pays for them, the utility of all workers is higher.

• However, social protection programs have contradictory effects on the government’s social objectives.

( ) (1 )f i f f i f f i iMPL MPL w T w T T

25

Illegal behavior: evasion of regulations on Illegal behavior: evasion of regulations on salaried labor salaried labor • When workers and firms hiring salaried employees have incentives to

evade the Law.

• Firms pay fines of F > Tf if they are caught evading.

• Enforcement may be imperfect and there is a probability of being fined, .

• Evasion creates salaried workers without social security, Lif, receiving a wage wif that compensates them for not receiving social security benefits.

Although the illegal act is committed by the firm, both firms and workers may benefit from evasion. As a result of it, not all salaried workers are formal. Illegality creates the need for a distinction

between formal workers and salaried workers.

[0,1]

1f

26

Minimum structure of the problem:Minimum structure of the problem:• Firms hiring salaried workers maximize profits mixing Lf and Lif

• Firms engaging with non-salaried workers maximize profits

• Workers maximize utility and all are employed

informal employment

salaried employment

Note: The equilibrium probability of being fined, , is determined endogenously along with wage rates [wf*, wi*, wif*] and employment levels [Lf*, Li*, Lif*].

( ) / [ (1 ) ] 0wf f if f f f fp Q L L L w T

( ) / [ ( ( ) / ). . ] 0wf f if if if if if ifp Q L L L w F L L F L

( ); ' 0ifL

/ 0wi i ip Q L w

( ) ( )i i i if i iw T w T ( ) ( )if i i f f fw T w T

i if fL L L L

*

27

The labor market with evasionThe labor market with evasion

Evasion increases salaried employment (good for labor productivity!) but higher informal employment defeats the government’s social objectives. Worker’s utility is higher with evasion. Social security contributions fall. Since firms cheat, taxes are also lower. Spending on social protection programs is higher.

K = formal employmentwithout evasion,

G = formal employmentwith evasion

H = salaried employmentwith evasion

Lif salaried workers arehired illegally.

28

In sum, social policy induces informality for four In sum, social policy induces informality for four reasons:reasons:

• Because non-salaried workers are excluded from social security;

• Because social security acts like a tax on salaried labor;

• Because social protection acts like a subsidy to non-salaried labor;

• Because firms and workers in salaried relations engage in illegal behavior generating illegal (informal) salaried labor.

Informality has other causes: tax regulations, costs of registration and operation. But social programs matter.

29

(1-βf ) Tf Lf = De facto taxes paid on

formal labor

≈ 2.4% of GDP

θf Tf Lf = Subsidies to formal labor

≈ 0.6% of GDP

(Lif + Li )Ti = Subsidies paid to informal labor

≈ 2% of GDP(of which 0.65% of GDP are subsidies to workers

hired illegally)

This is the distribution of Mexico’s non-public labor force in 2006.

Observed labor allocations and wage rates in Mexico reflect Observed labor allocations and wage rates in Mexico reflect large tax-cum-subsidies associated with social policylarge tax-cum-subsidies associated with social policy

30

Policy needs an integrated view of social programsPolicy needs an integrated view of social programs

Tf Ti

Lf- + + - -

Li+ - - + +

Lif+ - - + +

wf+ - - + +

wi- + + - -

wif- + + - -

Note that: but

so that the government is caught in a dilemma.

This is a BIG problem.

ff i

/ 0iTFP T / / 0f i i iU T U T

31

What do we know about the impact of TWhat do we know about the impact of T ii on (L on (Lii+ L+ Lifif)?)?

Juarez (2008) finds that a free health insurance program for women without social security coverage in Mexico City increases the probability of informal employment by women by …..

Bosch and …. (2010) find a positive impact of “Seguro Popular” on informal employment in Mexico. Over the period 200x to 200x they find that formal employment was xx% lower as a result of this program. Effects are concentrated on younger workers, and on increased illegal employment by smaller firms

Galiani and Gertler (2010) find that a non-contributory pension program increases informal employment in Mexico, with effects concentrated on older workers.

But note that Ti has been positive for decades!

There is evidence of negative impacts on formal There is evidence of negative impacts on formal employment of federal social protection programsemployment of federal social protection programs

32El Seguro Popular ha convertido alrededor de 380,000 empleos formales en informales. Falta evaluar el impacto de otros programas similares.

Preliminary results show that between 2004 & 2009 “Seguro Popular” has converted around 380,000 formal jobs into informal.

Source: Bosch et al. (2010)

And state-level programsAnd state-level programs

33

Impact of the Federal District Health Program for Women (PSMMG)

Source: Juárez (2008).

Firm Behavior Under Informality

34

35

Firms’ react to the distortions in labor costs Firms’ react to the distortions in labor costs implicit in social programs*implicit in social programs*

Firms face a tax of 26% of wf when hiring unskilled salaried workers

and a subsidy of 8% of wi or wif when engaging with non-salaried workers, or hiring salaried workers illegally. On this basis:

– Firms change labor contracts from salaried to non-salaried. There is a lot of simulation, rotation, and so on (…. and a lot of work for lawyers!).

– Firms legitimately hiring non-salaried workers and self-employment expands.

– Firms hiring salaried workers cheat and, given enforcement, adapt their decisions on size of the firm and duration of job offers to workers.

In any given year there are more than 15 million changes of registration of In any given year there are more than 15 million changes of registration of workers in IMSS, for a total formal labor force of around 14 million workers.workers in IMSS, for a total formal labor force of around 14 million workers.

*(Since I focus on social policy, I ignore issues of credit, registration costs, income taxes and other policies that are also relevant to firm behavior.)

(1 )f fT

i iT

36

Firms have large incentives to engage in illegal Firms have large incentives to engage in illegal behavior…..behavior…..

wif

Fully illegal and informal

L

Registered with IMSS but mix of formal and infor-

mal workers

Registered with IMSS and all formal workers

L1 L2 L3

wf + Tf

MCL

D1s

D2s

D3s

A

B

C

Depending on production technologies (particularly capital indivisibilities) firms may find it profitable to be fully legal, semi-legal or fully illegal. The distribution of firms across legal status is endogenous to social programs.

Steel or auto productionare not profitable at small scales(relative to ), andtherefore firms arealways formal; but manyactivities in light manufacturing,services, commerceand transportation are.These are “informalityprone” activities.

(.)

37

…… …… which matters a lot for productivitywhich matters a lot for productivity

• firms mixing legal and illegal workers face increasing MCL so producing more output is more costly than for fully legal or fully illegal firms;

• goods that are close substitutes or even the same goods are produced by

firms of various sizes, with similar workers having different productivities.

As a result:

• the marginal productivity of salaried labor ranges from a low of wif to a high of (wf + Tf), so that there is a continuum of labor productivities;

• the average of the marginal productivities of labor depends on the distribution of salaried workers across firms and on the size distribution of firms. The greater the proportion of workers employed in illegal or semi-illegal firms the lower is this average.

38

INEGI vs. IMSS: Registries of firms and workers, INEGI vs. IMSS: Registries of firms and workers, 20032003

Size INEGI IMSS Diference %(1) (2) [(1) - (2)]/(1)

(number of workers) Number of

firms workers Number of firms workers Number of

firms workersfrom to

0 5 2,699,400 5,089,925 533,891 1,175,242 80.2 76.96 10 153,891 1,135,021 95,886 725,253 37.6 36.1

11 50 118,060 2,477,868 101,721 2,174,280 16.1 12.251 100 16,100 1,135,608 15,337 1,077,909 4.7 5.0

101 más 17,563 6,262,900 16,956 6,025,824 3.4 3.7

Total 3,005,014 16,101,322 763,791 11,178,508 74.5 30.5

•90% of firms have five workers or less; •Only 1.1% have 50 or more workers (less than 34,000);

•75% are informal.

39

On average, small firms are less productive*On average, small firms are less productive*

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Productivity relative to the average sector. Average sector=1.

[0-10]-Mx'04 [11-100]-Mx'04

[101-500]-Mx'04 [+500]-Mx'04

278,872 fixed manufacturing establishmentscaptured in the 2003 Census

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Weighted Productivity relative to the average sector. Average sector=1.

[0-10] [11-100]

[101-500] [+500]

TFP above the average of the 4 digit activity

TFP below the averageof the 4-digit activity

* Tsieh and Klenow (2009) and IDB (2010).

40

The very large number of small establishments reduces The very large number of small establishments reduces average TFP in the manufacturing sector average TFP in the manufacturing sector

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Weighted Productivity relative to the average sector. Average sector=1.

[0-10] [11-100]

[101-500] [+500]

[0-10] 252,396 establishments, 90.5%

[11-100] 22,191 establishments, 7.9%

[101-500] 3,489 establishments, 1,2%

[+ 500] 796 establishments, 0.3%

Productivity relative to the average of the sector (=1)

On average, informal firms are less On average, informal firms are less productiveproductive

0

.1

.2

1/1024 1/256 1/16 1 4 16

Total Informal Semi-formal Formal

Grado de informalidad

Fuente: Elaboración propia con datos de los Censos Económicos, INEGI.

Total y según grado de informalidad

Distribución de TFPQ:Manufacturas+Comercio+Servicios, 2004

41

42

Services and commerce have larger TFP lossesServices and commerce have larger TFP losses

Number of Establishments, 2003 Economic Census

# Workers. Manufactures Commerce Services

0-10 252,396 1,288, 233 771,125 11-100 22,191 35,357 38,274 101-500 3,489 2,449 2,219 + 500 796 104 181

*Assuming the MP of L and K are equalized across all plants at the 4-digit level.

Calculations for other sectors like agriculture and constructions are still pending. However, the evidence so far shows that in Mexico informality is very costly in terms of foregone productivity.

Potential gains In TFP* 95% 267% 246%

Diference between percentil 90/10 (logs) 3.89 4.90 4.15

43

If the dispersion in marginal products in Mexico was equal to If the dispersion in marginal products in Mexico was equal to the US, TFP in manufacturing would be 36% higherthe US, TFP in manufacturing would be 36% higher

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Productivity relative to the average sector. Average sector=1.

México 2004 EE.UU. 1997

0

.1

.2

.3

1/1024 1/256 1/16 1 4 16

Productivity relative to the average sector. Average sector=1.

Mexico 2004 US 1997

Productivity relative to the average of the sector

EU 1997

México (2003) EU (2003) Est Works Est Works

1-9 90.5 22.7 54.5 4.210-19 4.2 5.5 14.5 4.820-49 2.7 8.0 14.7 11.0 50-99 1.1 7.5 7.4 12.3100+ 1.6 56.3 8.9 67.7

1% in 0 to 2 6% in 0 to 2

2% in 3 to 5

3% in 3 to 5 2% in 6 to 10

1% in 6 to 10

5% in 11 to 501% in 11-50

13% in 51 or more

1% in 51 or more

10% Public workers1% in rural areas

16% in rural areas

3% in more than 5

3% in more than 5

15% in 2 to 5

12% alone

Distribution of Mexico's Occupied Labor Force, 2003

Total: 40.6 million

The Census Data fails to capture urban workers that carry out activities outside a fixed establishment. Excluding public workers, about 45% of all urban workers are in this category. A challenge is to measure TFP losses as a result of self-employment.

Dark Light

Informal Formal

Blue + Red= urbanGreen= rural

2003 Occupied population= 40,622,6222003 Occupied population= 40,622,622

45

Dark Light

Informal Formal

Blue + Red= urban16.2m + 13.7m= 29.9m

Green = rural =6.5m

2008 Occupied population= 43,866,6962008 Occupied population= 43,866,696

46

Blue + Red= urban20.2m + 13.5m= 33.7m

Green = rural =5.6m

47

CENSUS DATACENSUS DATA ENE AND ENOE DATA

Differences between 2008 and 2003 Differences between 2008 and 2003 (in # workers and %) (in # workers and %)

Note: Average annual GDP growth was 3.4% during this period.

48

Informality is bad for growth….and for workers

• In Levy (2008) I show that when and Ti > 0, rates of return on investments in informal firms increase, and that this results in a suboptimal allocation of capital and a lower rate of growth of GDP.

• Economies of scale and scope may be under-exploited. Maloney (2006) finds that increases in formality increase firm’s survival rates and brings firms’ closer to their optimal size. Lopez-Acevedo (2006) finds that smaller firms are between one fifth and one sixth less likely to invest in workers’ training and to adopt new technologies.

• Transaction costs in the sense of Coase may also be higher because of sub-optimal vertical integration.

• Many firms in the border of formality and informality have high failure rates, or change labor contracts continuously. This partly explains the high levels of formal-informal mobility of workers. Precarious or unstable jobs with low wages result from precarious and unstable firms.

1f

Informality of firms increased between Informality of firms increased between 1998, 2003 & 2008 1998, 2003 & 2008

Share of establishments captured in Census without Share of establishments captured in Census without registration in IMSS, 1998, 2003 y 2008.registration in IMSS, 1998, 2003 y 2008.

50Note: Large firms may have more than one registry in IMSS although they are counted as one firm in the Census.

51

Three times more subsidies for social protection programs Three times more subsidies for social protection programs vs. social security: 1.8 vs. 0.6% of GDP in 2007 vs. social security: 1.8 vs. 0.6% of GDP in 2007

Public Resources for Social Programs, 1998-2007 (millions of pesos of 2007)

35,000

55,000

75,000

95,000

115,000

135,000

155,000

175,000

195,000

215,000

235,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Total Social Security Social Protection

Variation 2007/1998: 90.1 % 57.7 % 108.0 %

Social protection excludes resources for poverty alleviation programs

These trends will worsen under the current arquitecture of social programs.

Subsidies for Social Protection and Social Security (milions of pesos, 2007)

52

Mexico might be caught in a vicious circle of Mexico might be caught in a vicious circle of informality and low productivity.informality and low productivity.

• Many factors interact, including fiscal regulations and credit problems. But social policy stands out because it is the equivalent of a tax on size and a subsidy to dispersion.Many factors interact, including fiscal regulations and credit problems. But social policy stands out because it is the equivalent of a tax on size and a subsidy to dispersion.

““bad jobs”bad jobs”

More social programs for More social programs for informal workersinformal workers

Lower productivity and Lower productivity and more evasionmore evasion

More More subsidies to subsidies to the informal the informal

sectorsector

53

Informality and Poverty

54

Informality and povertyInformality and poverty

• This line of work is relevant to the “post CCT” discussion.

• In Levy (2008) I argue that and and show that this helps to explain this puzzle:

– why, if most poor workers have no assets other than their labor, they end up in informal jobs, when the expectation would be that they should have formal jobs?

There is an incentive-compatibility problem between Progresa, on one hand, and social protection and social security programs, on the other.

P NPf f P NP

i i

55

a ) L P+1 = L P

– R P + L P – L P,NP

+ L NP,P

b) L NP+1 = L NP

– R NP + L NP + L P,NP

- LNP,P

Poor workers futurecapabilities

Incentives to firms andworkers

Outcomes in the labormarket

Progresa -Oportunidades subsidizes the demand for health and education

of poor children and youngsters

Social security and social protection programs distort firm’s and workers decisions in the labor market

fP <

fNP ; i

P > iNP

T i

P > T iNP ; T f

P = T fNP

U fP = U i

P

U f

NP = U iNP

but

MPL f > MPL i

and

(L fP /L P) < (L f

NP /L NP )

c) L f +1 = L f – R f + L f – L f,i + L i,f

d) L i+1 = L i – R i + L i + L f,i - L i,f

Progresa cannot fix the problems created by the formal-informal dichotomy. Raising benefits in Progresa indefinitely cannot substitute for a job with higher labor productivity. And raising Ti to increase the welfare of poor workers makes the productivity problem worse.

Concluding Remarks

56

1. Need more accuracy in the expressions “formal” , “informal”, “social safety nets”, “social protection” and “social programs”.

2. Need to distinguish between programs that provide insurance to workers regardless of income levels, but based on labor status (salaried vs. non-salaried and social security vs. social protection), on one hand; and programs that provide income transfers regardless of labor status, but based on income levels (with or w/o

associated investments in HK).

3. Need to understand better the incentives of each, and of their interaction. This involves analysis of the “arquitecture” of social policy. Impact evaluations of programs do not pick this up. Need to evaluate how various programs interact, in addition to individual programs.

57

Mensajes principales:Mensajes principales: 4. Social programs can have unintended perverse incentives. I have focused on formal – informal choices of firms and workers. This is critical, but attention is also needed to labor – leisure choices. I think this partly explains the “productivity puzzle in LAC” [IDB (2010)].

5. Serious concerns about the direction of social policy. These issues are critical for the design of economic and social policies in LA.

6. The fiscal dimensions of social policy need a lot more attention. To

escape the dilemmas posed by the formal-informal dichotomy, I propose universal social rights financed with consumption taxes, delinking (by-and-large, although not completely) social insurance from labor status. (A major rethinking of some aspects of social and fiscal policy.)

THANK YOU!58

59

Can Social Policy Increase Welfare Can Social Policy Increase Welfare and Growth?and Growth?

60

Policy needs to begin by recognizing that the Policy needs to begin by recognizing that the government is trappedgovernment is trapped

• The institutional distinction between the rights of salaried and non-salaried workers creates a formal-informal dichotomy;

• From the social point of view, the government cannot leave workers excluded from social security without protection against social risks;

• However, the instruments used do not really solve the social problem (contribution densities to pensions are low, workers are only protected against some risks when they are formal, and so on), while at the same time deepen the reasons that account for bad firms and bad jobs, low productivity and low growth;

• In parallel, the government de facto subsidies illegal behavior, and undermines the tax base and the Rule of Law (as Lif workers cannot be left without social benefits).

61

The policy challenge has two parts:The policy challenge has two parts:

• From the social point of view, to insure that all workers are protected all the time against the relevant social risks regardless of whether they are salaried, self-employed, or comisionistas;

• From the economic point of view, to provide benefits with programs that by-pass the distortions in the allocation of labor and capital and place the economy on a higher growth path with faster increases in labor productivity.

It is essential to focus on both objectivesSIMULTANEOUSLY.

(A big problem in Mexico is “piece-meal” policymaking.)

62

Proposal for universal social entitlementsProposal for universal social entitlements

Simple idea: provide all workers with (almost) the same bundle of social benefits; make these benefits a legal entitlements; and fund all these benefits with a consumption tax earmarked for these benefits.

Key point: Firms and workers cannot avoid this tax by changing status between salaried and non-salaried employment, so:

– no taxes on firm growth;– no subsidies to self-employment;– no subsidies to small illegal firms;– no reasons to change the duration of labor contracts or disguise salaried employment relationships as non-salaried;– distortions in the allocation of capital and labor coming from social programs are (practically) eliminated.

Observation: The result would be the same as if all workers were salaried and social security contributions were fully enforced. But since there are efficient reasons for non-salaried employment, and enforcement will never be perfect, universal social security will never be reached under the formal-informal dichotomy.

63

Social security contributions (A) vs. consumption taxes (B)Social security contributions (A) vs. consumption taxes (B)

If all workers were salaried, and if there was no evasion, and if consumption taxes could be ear-marked to pay for social security benefits, then social security contributions and consumption taxes would be equivalent.

64

Social Policy: Status-Quo vs. Core ProposalSocial Policy: Status-Quo vs. Core Proposal

[... ... ... ... ...]

[... ... ...]

/ [ (1 ) ] 0

/ [ ' ] 0

/ 0

[ ( )]

f

i

f f f f f

f if if if

i i i

f f f if i i i i i

f if i

ns os f f f i if i c

T

T

Q L w T

Q L w F FL

Q L w

w T w T w T

L L L L

G G T L T L L R R OR

Status-Quo Core Proposal

*

* *

* *

[... ... ...]

/ 0

/ 0

( )

f f f

i i i

f i

f i

ns os f i c c

T

Q L w

Q L w

w T w T

L L L

G G T L L R R R OR

T* is the bundle of social benefits that the government considers that all workers should have (see below), and is worker’s valuation of that bundle; R*c reflects those consumption taxes that are specifically earmarked to pay for universal social benefits and that result from higher consumption tax rates, so that: T*(Lf + Li) = R*c.

65

Workers’ utility: status quo vs. core proposal Workers’ utility: status quo vs. core proposal withoutwithout redistribution redistribution

Status quo Core proposal

Worker’s utility

Government’s budget

SQ SQf f f f cU w T t

SQ SQi i i i cU w T t

* * * ( )f c cU w T t t * * * ( )i i c cU w T t t

( ) [ ( )]SQ SQ SQc f f f i i ift L T L T L L *( )c ct t L T L

Under the core proposal the government’s objectives are fulfilled with all workersbut worker’s utility may or not be higher.

* * *( ) ( )SQ SQf f f f f f cU U w w T T t

+ ? -

66

Workers’ utility: status quo vs. core proposal Workers’ utility: status quo vs. core proposal withwith redistribution redistribution

Status quo Core proposal

Worker’s utility

Government’s budget

SQ SQf f f f cU w T t

SQ SQi i i i cU w T t

* * * *( )f f c cU w T t t s

* * * *( )i i c cU w T t t s

( ) [ ( )]SQ SQ SQw f f f i i ift L T L T L L * *( ) ( )c ct t L T s L

To achieve both the objective of changing the composition of all worker’sconsumption and increasing the level of some worker’s consumption you needtwo instruments. The proposal is to Slutsky-compensate (or more) a subset ofworkers with direct income transfers, choosing s* such that:

* * * *( ) ( ) 0SQ SQf f f f f f cU U w w T T t s

67

How much would universal entitlements cost?

Estimated Net Fiscal Costs of Universal Social Entitlements(millions of pesos of 2007)

Workers and Government

firms contributions contributions

Total 14.1million workers

Total 41.4

millionworkers

1. Health insurance2. Retirement pensions3. Life and disability Insurance

90,275 39,154

58,681 18,932

23,177 0

129,42977,61323,177

375,344184,56154,896

Gross total Less: resourcesalready in budget Net total (% of 2007 GDP)

172,133 58,086

230,219614,801218,586396,215

(4.3)

t*c = 4.3% GDP But was 2.7% and now is 0, so net t*c = 1.6% GDP

The proposal implies increasing the VAT and (almost) eliminating labor taxes:a large change in the composition of taxation from labor to consumption.

(1 )f f fT L

68

Social security and social protection Social security and social protection programs impact the budget on both sidesprograms impact the budget on both sides Resources for social security and social protection programs for active workers

• It is important to separate social spending on social security and social protection programs as defined from other social spending.

• As Ti increases there are more pressures on the budget, since incentives to firm’s illegal behavior are higher (and profit taxes lower), while the number of informal workers receiving free social benefits increases.

• The question is how the reform changes the budget constraint of the government as output levels and the incentives to evade change .

(..) [ (..) (..)] (..) (..)ns os f f f i i if cG G T L T L L R R OR

Resources for education, targeted poverty programs,

and other socialspending.

Consumptiontaxes depend on real wagesand evasion ofVAT

Profit taxesdepend on thenumber of firmsthat are formal andevasion behavior

69

Structure of benefits Observations1. Income transferss* same amount all workers Workers in households up to the third decile

receive a net income transfer

2. Re-design of social security

T* = [health insurance retirement pensions Bundled protection for all workers for these risks

life insurance disability insurance]

Tf Tf* = [work-risk insurance unemployment Salaried workers get additional protection for insurance] risks specific to salaried work

Other = [housing loans + day care centers benefits + sports and cultural facilities] These benefits are not legal entitlements

Labor Market Firms hiring salaried workers pay for Tf*

( 4%)

Non-salaried workers do not get Tf*

Wage-based benefits distort only if ; note

that Tf* contains only monetary benefits, so

Full de-linking and full un-bundling is not desirableFull de-linking and full un-bundling is not desirable

*/ ( ) 0f f f fQ L w T

/ 0i i iQ L w

* * * *f f f iw T T w T

* 1f

Note: This scheme allows for a two-pillar retirement pension system (only when workers are salaried-employed), by including a retirement pension component in Tf*.

* 1f

70

A Digression: The VAT in MexicoA Digression: The VAT in Mexico

71

Note that:

• In 2006 VAT revenues in Mexico were only 4.2% of GDP, with an average VAT rate of around 8% because of many exemptions on food, medicines and the like justified on redistributive grounds;

• The proposal takes advantage of Mexico’s extremely high unequal distribution of income and consumption: out of every peso of additional revenues from VAT only 10 cents are required to Slutsky-compensate the first two deciles and 27 cents the first five deciles (Davila and Levy, 2003);

• The proposal implies setting a VAT rate of 15% with no exceptions, and compensating all workers with a direct income transfer that leaves households in the first two deciles of the distribution with the same real income as before.

72

The distribution of consumption is very The distribution of consumption is very skewed in Mexicoskewed in Mexico

0

10

20

30

40

50

60

70

80

90

100

20 40 60 80 100% share of households

% s

hare

of m

onet

ary

cons

umpt

ion

31.915.010.98.24.9

70.9% of GDP

45.021.115.411.56.9

100% consumption

The poorest four deciles account for less than 18% of all consumption, while the richestfour deciles represent more than 66%, according to the 2006 income-expenditure survey.

73

The VAT is a good instrument to raise revenues in Mexico. The VAT is a good instrument to raise revenues in Mexico. The proposal is to tax all goods at the same 15% rateThe proposal is to tax all goods at the same 15% rate

2.741.401.050.800.48

6.5% del PIB

010002000300040005000

6000700080009000

1000011000

20 40 60 80 100Percentile of households

Add

ition

al c

onsu

mpt

ion

taxe

s (p

esos

per

mon

th)

Only 7.3% of the additional revenues would come from the first two deciles, and 20% from the first four deciles, while the richest four deciles would pay 64%.

74

Additional VAT collections are fully returned

to workers at the level of the second decile

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

11000

10 20 30 40 50 60 70 80 90 100

Percentiles de los hogares

Imp

ue

sto

ad

icio

na

l al c

on

sum

o (

pe

sos

po

r m

es)

Beneficios sociales universales adicionales 4.2% del PIB*

Transferencia Monetaria por compensación 2.3% del PIB**

Recaudación adicional del IVA 6.5% del PIB

-2.74-1.40-1.05-0.80-0.48+0.44+0.46+0.47+0.46+0.48+0.74+0.85+0.87+0.84+0.89

-1.36+0.2+0.29+0.50+0.89

-6.5+2.3+4.2

-0.0

* Equivalente a 800 pesos mensuales por trabajador** Equivalente a 435 pesos mensuales por trabajador

75

Redistributive impactRedistributive impact

I (más pobre) 6.9 7.3 8.2II 11.5 11.8 12.3III 15.4 15.5 15.8IV 21.1 21.1 21.0V (más rico) 45.0 44.3 42.7Total 100.0 100.0 100.0Coef. Gini 0.459 0.448 0.429Indice Theil 0.390 0.371 0.340

Quintil AntesAfter transfers

por compensación

para beneficios sociales

76

Work in progress:Work in progress:

• Study the incentives to evade VAT under the proposal, comparing a VAT reform on its own with a (VAT + social) reform;

• Study firms’ incentives to evade income taxes, again in the two scenarios;

• Study an unemployment insurance that has lower efficiency costs than the current system of severance pay and improves benefits to workers; and,

• Consider the productivity and the social welfare side at the same time, but think of all these themes as “pieces of a puzzle” and not in isolation.

Thank you!